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This may not be the best time for investors to be piling into the defense and aerospace sectors, but selective stock pickers can still profit.
First, let's set the scene. U.S. Defense Secretary Robert Gates recently outlined a plan for the Pentagon to save up to $100 billion over the next five years on defense spending.
Many contracted corporations have been large beneficiaries of the nearly $700 billion a year the Pentagon spends on its defense budget. But these companies have been making cuts as they brace for continued cutbacks in federal spending.
Defense contractor Lockheed Martin (NYSE: LMT ) recently let more than 1,000 workers go, including 600 executives who have accepted buyouts from the company. Northrop Grumman (NYSE: NOC ) laid off hundreds more workers. Competitors like Raytheon (NYSE: RTN ) and General Dynamics (NYSE: GD ) , which derive large sums of their revenues from the federal government, will also no doubt see declining sales and reduced workforces.
Even more diversified businesses, such as General Electric (NYSE: GE ) and United Technologies (NYSE: UTX ) , will be hurt by the cutbacks. These companies are vying to build new engines for combat aircrafts that have also come under budget scrutiny.
A cheap way to stay in the sector
While spending cuts and troop withdrawals will certainly affect companies that do defense work for the federal government, there are still some extremely cheap stocks in the sector. One in particular is Force Protection (Nasdaq: FRPT ) . The stock was even cheaper just a few days ago as it hovered around $4 per share, but news that the company has been selected to provide light protected patrol vehicles to the U.K. Ministry of Defense boosted shares by more than 13%, to around $4.75.
Force Protection provides vehicles such as these to militaries across the world. Its vehicles are made to protect soldiers from blasts and mine explosions, which is clearly an essential feature in today's combat situations.
Even with the recent appreciation in share price, the company is still undervalued, especially considering the value of its assets. The stock trades just slightly above its book value (as of June 30) of $4.53, at just 1.05 book. Force Protection has no long-term debt on its balance sheet, and more than $120 million in cash. This cash is also cushioned by a current asset to current liability ratio that is greater than 2:1.
So, on the surface the stock clearly looks cheap relative to its peers. However, investors must also be wary, as the stock has been trading at such a discount for a reason. Force Protection won't be immune to U.S. budget cuts. With spending still increasing in 2008, Force Protection's revenues reached a top at $1.32 billion. In 2009, as spending began to slow, the company's revenues dropped to $977 million. While U.S. government spending is essential for revenue and earnings growth, Force Protection has a diversified clientele and an important product for many militaries, as its recent deal with the U.K. proves.
The Foolish bottom line
Force Protection's margins reached 23% last quarter and long-term projections are for about 20% margins, putting the company ahead of competitors that are valued at a much richer valuation. The company should also benefit as governments that are cutting back on spending look to spend more efficiently. While Force Protection may have lost several high-profile contracts, it still stands to gain as its large fleet of vehicles in the field need to be serviced and upgraded.
This puts Force Protection -- with its advanced technology, modern, and longer-lasting vehicles -- in the sweet spot of many shrinking budgets. While investors should certainly be careful in a sector that in the near terms is slowing, Force Protection is a low-risk, high-reward opportunity.
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